Good question. I’m not an accountant, so I sent this to my accountant (who is an accountant) to answer. Here’s his response:
If there is a physical injury, the settlment for it is exempt from taxation. If the settlement is for anything other than for physical injury (i.e. emotional duress, loss of wages) it’s fully taxable.
Matt is a very nice guy, but he doesn’t waste words.
As I understand it, the reason you’re not taxed on compensation for injuries is because the money you get was “taken from you” at the time of the accident, and the settlement is just returning to you what was already yours. It’s not income, since that money is just intended to get you back to zero.